If your business is expanding its geographical footprint beyond state or U.S. borders, it’s important to understand the transfer pricing rules. In a nutshell, transfer pricing refers to cross-border pricing arrangements for transactions between related companies (including parent and subsidiary or brother-sister companies with a common parent) in different jurisdictions.

Typically, these transactions involve charges for goods, services or intellectual property (such as licensing arrangements) transferred from one company to its affiliate. Because these arrangements can be highly susceptible to manipulation to minimize a business’s tax liability, taxation authorities around the world are becoming stricter in regulating them.

Why It Matters

Here’s a simplified example that illustrates the potential for manipulating transfer pricing to avoid taxation. Let’s say that BroCo and SisCo are related companies with a common parent. BroCo is based in a country with a 30% corporate income tax rate, while SisCo is based in a country with a 10% corporate income tax rate.

BroCo manufactures component parts at a cost of $2 million per year and sells them to SisCo for $4 million, earning a $2 million profit. SisCo assembles the parts into finished products, which it sells for $6 million, also earning a $2 million profit. BroCo’s tax liability is $600,000 ($2 million × 30%), while SisCo’s tax liability is $200,000 ($2 million × 10%). Therefore, the enterprise’s overall tax liability is $800,000.

Now suppose that BroCo lowers the price it charges SisCo for the component parts to $3 million. In that scenario, BroCo’s profit is reduced to $1 million, and its tax liability is reduced to $300,000 ($1 million × 30%). SisCo’s profit increases to $3 million, and its tax liability increases to $300,000 ($3 million × 10%). Thus, the enterprise’s overall tax liability drops from $800,000 to $600,000. The higher-tax country in which BroCo is based stands to lose significant tax revenue by this change in intercompany pricing — and might initiate a transfer pricing audit.

How It’s Regulated

Transfer pricing regulations are intended to prevent related companies from manipulating intercompany pricing to shift profits to lower-tax jurisdictions. A complete discussion of these regulations is beyond the scope of this article, but generally speaking, they require the terms of intercompany transactions to be comparable to arm’s-length transactions between unrelated companies.

There are several methods for setting acceptable transfer prices. For example, the comparable profits method estimates the arm’s-length price by analyzing the profitability of comparable transactions involving similar companies. Another example is the cost-plus method, which determines the costs incurred by the “supplier” and applies a market-based markup to arrive at an appropriate profit.

Transfer pricing regulations generally require companies to use the best method based on their circumstances. Some jurisdictions require companies to furnish documentation to support their transfer prices. But even if not required, it’s advisable for companies that conduct cross-border business with related companies to maintain documentation that details the methods they use to set prices. In the United States, if the IRS requests transfer pricing documentation, taxpayers have only 30 days to provide it.

The consequences of noncompliance can be harsh. Under U.S. law, for example, on top of back taxes and interest, companies can be hit with penalties as high as 40% of the tax underpayment (depending on the circumstances).

What You Should Do

If you’re concerned about transfer pricing, start by conducting a risk assessment. The higher your risk, the more important it is to invest in transfer pricing compliance.

The next step is to review and evaluate your transfer pricing policies and procedures, if any. Implement policies and procedures that are appropriate based on the nature of your business and incorporate the best methods for determining arm’s-length prices. Finally, document your methodology to help support your position in the event of a transfer pricing audit.

Not Just for Megacorporations

Transfer pricing is often associated with large, multinational corporations, but it may affect companies of all sizes. Transfer pricing issues can even apply to domestic companies — for example, related companies in states with different tax rates. If you’re unsure of your transfer pricing obligations, consult with us.